These issues don’t as such relate directly to default risk, but rather to a country’s long-term financial stability.

“For example, poor management of resources could make a country’s economic growth rate unsustainable, and weaken public finances in the longer term. Similarly, weak government institutions could lead to mismanagement of financial resources, and impair both a country’s willingness and ability to repay debt,” says Mervyn Tang, an ESG researcher at MSCI.

Such risks are often not fully priced in, making it worthwhile for investors to take sovereign ESG ratings into account.

Tang suggests ESG country risk is not just an issue for government bond investors, but could also impact other asset classes.

“Sovereign credit risks could be transferred to corporates and financial institutions through a variety of mechanisms, for example taxation and other policy changes, financial market instability and the likelihood of government support,” says Tang.

An increase in sovereign credit spread is also associated with statistically and economically significant increases in corporate spreads, and hence firm’s borrowing costs.

This relationship is especially strong for companies in the financial sector.

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